In the short term, a trip to France sounds great - I must agree. In the long term, you may regret how you funded that dream vacation - especially if funded through a loan from your 401(k) plan. Perhaps a simple road-trip down to the beaches of Carlsbad, CA would have been more prudent. When is it appropriate to access this retirement fund that we're all told to leave and forget about until retirement? With each quarterly investment statement received, we're reminded of this sum of money, destined to replace the income lost when we eventually retire. This important retirement vehicle called the profit sharing plan and/or commonly referred to as your 401(k) plan (due to the ability to defer salary) is counted upon to fund much of our retirement needs. During our working years, the IRS allows us to reduce the taxes paid on wages through deferral of salary, invest & grow these savings tax deferred, and access these funds while in retirement without penalty. Why would anyone want to mess with this perfect picture?
Some might argue that taking a hardship withdrawal and/or loan from your retirement plan defeats the purpose of having a retirement plan. Others point out that under difficult situations, borrowing from your 401(k) makes a lot of sense.
First, let's point out the obvious drawbacks of borrowing from your 401(k) plan.:
- Amount eligible to borrow is limited - the amount you borrow is generally limited to the lesser of $50,000.00 or 50% of your vested account balance; if your balance is less than $20,000.00, than you can borrow up to 50% of this amount ($10,000.00) Source:IRS
- Some employers will only allow loans for unreimbursed medical expenses, educational expenses, first-time home buyers, and financial hardships - others plans have no restrictions
- Payment of interest is made with after-tax dollars - subjecting these dollars to double taxation when withdrawn during retirement
- Opportunity cost (loss of appreciation potential): The amount borrowed no longer is invested and thus not capable of appreciating (or depreciating)
- Loan repayments must begin with the employees next pay-cycle and not stretch beyond 5 years (amortized) in length - unless the loan was used to fund the purchase of a primary residence (which provides for a longer repayment schedule)
- Interest is accessed on the loan balance, although this interest expense is paid back to the borrower - at typical interest rate paid by the borrower is the prime rate plus one or two percentage points
- Interest accessed on the loan balance is not tax-deductible
- You have to pay it back - If you lose your job (terminated/voluntary or layoff) you will be required to pay back the loan in full within 30 to 90 days of said date; if you can't pay it back, the loan is treated as a distribution, resulting in a taxable event (ordinary income taxes on the whole balance) and potential IRS early withdrawal penalties of 10% (on the whole balance) - not a pretty picture when all is said and done
- Loans outstanding from a retirement plan are not protected from bankruptcy proceedings - retirement plans are generally protected up to certain dollar limits, yet loans are not afforded this protection
Advantages of taking a loan from your 401k plan:
- Ease in obtaining the loan: you don't have to qualify or pass a credit check to qualify
- Loan proceeds aren't taxable - unless you default on loan repayments
- Interest charged on the loan is typically low, and repaid back to the borrower
- Loans are not accessed an early age (pre age 59 1/2) IRS withdrawal penalty, unless defaulted upon Speed - available within a few days of request
- Economic - no or low cost to originate the loan
- Few if any restrictions on how proceeds of the loan are used
Situations where taking a loan from your 401k plan might make sense:
- Potentially useful option for those who have trouble obtaining credit at affordable rates
- You've exhausted all other resources (such as an emergency fund , non-retirement and savings/checking account and family or friends)
- You have job security, tenure, and don't plan on changing jobs soon - these variables allow for enough time to pay-back the loan
- Under certain circumstances, borrowing from a 401(k) to purchase a home, finance a business or advance your education might be a viable options (the repayment period is often extended for homebuyers)
- You have a short-term (less than 1 year) liquidity need and all other options (access to cash) have been exhausted
- Timing - you have a short term liquidity need and feel the stock market will decline in value
The long-term benefits of avoiding loans from 401(k) plans far outweigh the short-term benefits. Unless a short term specific need arises, and you're left without alternative options, then taking a loan from your 401(k) balance should not be considered. Prior to borrowing from your plan, explore all available options, such as non-retirement accounts, checking/savings accounts, and potential bridge loans (from family or friends). Essentially, the opportunity cost given- up (market appreciation potential), risks associated with leaving a job (terminated/voluntary/layoff), and loss of deferred compounding of appreciation are obstacles that detract from the decision to borrow. Given these detractors "life happens" and the ability to access a low cost, no credit check, lightening fast loan will benefit those in absolute need. Anything that puts your secure retirement at risk needs to be fully researched and if possible, avoided.
Author: Gregg F. Himfar CFP®
For questions and/or comments regarding this article, please contact Gregg F. Himfar CFP®
This information is intended for general information purposes only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult with your tax, legal and/or financial services professional regarding your individual situation.